Shining a Light on Sun Hydraulics

Royce & Associates has reported a position of 1.8 million shares in Sun Hydraulics (SNHY), an industrial equipment company specializing in cartridge valves. It has a market capitalization of about $710 million and trades almost 60,000 shares daily at $27.50 apiece with well over $1 million in daily dollar volume. The fund, managed by Chuck Royce, tends to invest in small- and mid-cap stocks, even if it means taking a larger stake. Royce's position has increased since the end of September, up from 1.6 million shares at this time last year.

In the third quarter of 2012, Sun Hydraulics experienced an 8% decline in revenue compared to the same period in 2011. There was very little change to costs -- selling, general and administrative expenses actually increased -- the result being a 22% drop in earnings. Both of these figures reversed trends from the first half of the year, when the company reported growth on both top and bottom lines. Looking at the company's geographic segments, the primary culprit for the decline was international operations (including both Europe and Korea), though U.S. operating income was also down by 9%. Combining results from the third quarter and the first two quarters of the year, sales and net income were about flat in the first nine months of 2012 vs. a year earlier. We'd conclude that Sun Hydraulics is, at best stable, and possibly beginning to see a decline in business.

Despite those business conditions, the stock trades at 19x trailing earnings, a multiple that generally implies significant growth rates over the next few years (and, therefore, one at which we'd expect to see earnings growth over the last year). In addition, the sell-side is actually forecasting slightly worse results for 2013 and so the current-year price-to-earnings ratio is 20. So the market is pricing in substantial beats. Seven percent of the outstanding shares are held short, so there is some short interest in the market though that figure is not particularly high. As expected for an industrial company, Sun Hydraulics has a high beta (2.3, to be precise) as demand for its products depends on economic conditions, therefore, the stock price tends to react strongly to changes in market indices.

Sun Hydraulics does have a considerable cash position -- almost $100 million in cash, cash equivalents and marketable securities at the end of September, along with about $30 million in other current assets and $22 million in total liabilities. Trailing earnings before interest, taxes, depreciation and amortization of $62 million -- and an enterprise value of about $620 million -- still generates a high EV/EBITDA multiple of 10x. As a result, accounting for the company's cash hoard doesn't improve the value prospects very much.

Parker-Hannifin (PH) also reported decreases in revenue and earnings in its most recent quarterly report compared with a year earlier, but that company is considerably larger at a market cap of $14 billion and its value metrics are more appealing. The trailing PE multiple, for example, is 14; the EV/EBITDA multiple is 8.4x. We wouldn't necessarily suggest Parker-Hannifin as a value stock, but we believe that it further demonstrates that Sun Hydraulics is not a good buy.

Royce's accumulation of Sun Hydraulics shares isn't a good move to imitate. The company is struggling, yet the valuation -- even if we account for the sizable amount of cash on its balance sheet -- is pricing in at least moderate growth, certainly more growth than is expected at one of its peers. With business down in both the U.S. and internationally last quarter, it's difficult to see any bright spots. We would avoid this stock.